Real-money investors are becomingly increasingly concerned about their ability to enter and exit bond positions, following the violent sell-off in risk markets in June that led to an evaporation of liquidity across a wider-than-expected range of asset classes.
Regulation has led banks to shrink their bond inventories to a fraction of their former sizes, making them less vulnerable to sell-offs, but also reducing their ability to buffer flows between buyers and sellers.
The brunt of June’s market sell-off was consequently borne by bond funds – which have mushroomed in size over the past few years – spurring a wake-up call for these prominent investors.
“June was volatile because banks were no longer there to provide liquidity and stabilise the markets. That’s OK for macro hedge funds that can unwind quickly, but it can take days or weeks for large asset managers. They’re getting increasingly worried they have this large inventory and no way to escape,” said Thibaut de Roux, head of global markets EMEA at HSBC.
Unable to find a bid for their bonds, bankers say investors turned to other asset classes to derisk, creating a spillover effect in volatility.
“This time illiquidity spread into assets people thought are liquid: linkers, emerging market sovereigns, foreign exchange. People took to shorting equities where they couldn’t sell bonds. In these situations, volatility can become self-fulfilling,” said Niall Cameron, head of credit trading at HSBC.
Increased capital requirements and curbs on proprietary trading have forced banks to shrink corporate bond inventories from a peak of US$233bn in 2007 to US$56bn today – just 0.25% of the total US investment-grade debt outstanding, according to BlackRock.
“This time illiquidity spread into assets people thought are liquid … in these situations, volatility can become self-fulfilling”
Meanwhile, the corporate bond market has doubled in size since the beginning of the previous decade, research from BNP Paribas shows, thanks to a glut of new issuance. The vast majority of this supply has been gobbled up by investors: bond funds saw over US$1trn of net inflows between 2009 and the end of 2012, according to Lipper.
The shift in market structure has made banks more resilient in the face of market sell-offs. Despite US Treasury yields jumping and credit indices widening in June, banks reported relatively solid second-quarter fixed income results.
But bankers warn it has left the market in a precarious position, with buyside bond portfolios now dwarfing those of their market-making investment banks. Many believe the market would struggle to absorb any kind of great rotation out of bonds if investors repositioned for a more positive growth world.
How liquid?
Some observers reckon banks overplay these concerns, not least because they have a vested interest in returning to trading large inventories of corporate bonds, an activity that has traditionally been hugely profitable.
After all, asset managers do not have to sell bonds if they are worried about rising interest rates, but can hedge through the derivatives market. Similarly, credit default swaps indices, which have gained in popularity in recent years, provide a more palatable way to express views on credit risk.
There is also a wider debate as to just how liquid corporate bonds should be, due to the fact that the large inventory banks held in 2007 coincided with a time of record-high leverage in the financial system.
“The years leading up to 2007 were the real aberration in terms of corporate bond liquidity. Historically, IG bonds haven’t been a liquid asset class, but a buy-and-hold investment,” said Andrew Sheets, head of credit strategy at Morgan Stanley.
Still, some prominent investors have expressed concern at the status quo. Trading volumes have fallen to around 75% of the total amount of debt outstanding compared with more like 125% in 2005, according to research from BlackRock.
The asset manager suggested in a report in May that companies should standardise bond issuance schedules to boost liquidity in the bond market. Such initiatives look set to become more commonplace.
“Regulators don’t want the fund holding your grandmother’s retirement savings to sell US$100m of bonds in one go and for the banks to warehouse the risk. Instead, they want to shift that execution risk to the buyside, which will be forced to trade in lots of smaller clips of US$10m each,” said one head of fixed income at a major bank.
“That may well reduce risk in the banking system, but it will mean the firms looking after people’s savings will have to take that hit instead.”
